Europe threatened with the slap of harsh reality

Commentary: Markets, policy makers lulled by ECB’s easy promises

LONDON (MarketWatch) — On the world financial and economic scene, we have seen an outbreak of a dangerous phenomenon that could have a greatly negative effect on policy. It’s called realism.

European leaders who agreed in Brussels on Friday to the first-ever cut to the European Union budget are just one example of the new trend. European governments, under pressure from U.K. Prime Minister David Cameron, set spending to the end of the decade at €960 billion. This is considerably lower than the €1.033 trillion, first proposed by the European Commission.

Cameron promptly claimed victory.

He may have a point. His accord on budgetary austerity with German Chancellor Angela Merkel gives the U.K. prime minister some hope that, in forthcoming wider negotiations on a new power mechanism for the European Union, he may find some useful allies.

The spending deal, which still has to be ratified by the European Parliament, limits the EU budget to 1% of gross domestic product, well below the 3% of GDP proposed by the European Commission in the 1990s as an appropriate level to make economic and monetary union (EMU) work.

So the European budgetary accord, emerging at a time when the euro area is once again looking wobbly after the revival in confidence in the second half of last year, is hardly encouraging for EMU supporters.

Another place where we’ve seen an outbreak of realism is in Beijing.

In March 2009, Zhou Xiaochuan, governor of the People’s Bank of China, caused a considerable stir by calling for replacement of the dollar as the dominant world currency. Instead, he urged “an international reserve currency that is disconnected from individual nations and is able to remain stable in the long run.” Four years later, all that has changed.

In an article distributed at the weekend, Jin Zhongxia, head of the research institute of the People’s Bank of China, said the dollar will remain the world’s dominant reserve currency and may even strengthen over time as the U.S. balance of payments improves.

Making his comments in a personal capacity, Jin said: “For the foreseeable future, we can speak of the global currency system as a framework of ‘1+4.’ The dollar will continue to be the super reserve currency, supplemented by four smaller reserve currencies: the euro and the British pound in Europe, and the Japanese yen and the Chinese renminbi in Asia.”

His use of the term “super reserve currency” was almost certainly no coincidence. This was exactly the same expression used in 2009 by Governor Zhou to describe a planned international currency, creation of which the Chinese authorities now appear to see as highly unlikely.

In Europe, central bankers are fretting that the revival in financial markets has become dislocated from still-dire economic reality. Another area where we may see some upheavals.

European central bankers have been saying, off-the -record, for some time that they could foresee dire outcomes if politicians continue to hide behind the ECB’s much-hyped but fundamentally untested promise “to do what it takes” to support the euro.

Now one former member of the 23-member ECB Governing Council has said this out loud. Athanasios Orphanides, former governor of the Central Bank of Cyprus, who stepped down from his job in May last year, is a fervent euro supporter who took the island state into the single currency in 2008.

But last week in Frankfurt he told a university audience that “the sovereign crisis is tearing the system [EMU] apart” and added: “states with the worst macroeconomic conditions are the ones with the highest interest rates … EMU has amplified heterogeneity rather than mitigating it.”

Although a supporter of the ECB’s attempts to stabilize markets through unconventional monetary measures, Orphanides said the ECB’s bailout actions provided a built-in reason for governments to slow their own structural reforms. This is an “impossible dilemma” for the ECB, he added.

Far from saving the euro, the ECB — by giving governments a false feeling of security that all may be well — could be storing up considerable trouble for the future. A dose of realism is not a pretty sight.

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